Closed-End Lease: Overview and Examples in Car Leasing

What Is a Closed-End Lease?

A closed-end lease is a rental agreement that puts no obligation on the lessee (the person making periodic lease payments) to purchase the leased asset at the end of the agreement. A closed-end lease is also called a "true lease," "walkaway lease," or "net lease."

Closed-End vs. Open-End Lease

There are typically two types of leases: an open-end lease and a closed-end lease. An open-end lease has more flexible terms and the lessee takes on the depreciation risk of the asset. In a closed-end lease, the lessor takes on the depreciation risk, but the terms are more stringent. Both of these leases usually apply to vehicle leases.

Since the lessee has no obligation to purchase the leased asset upon lease expiration and does not have to worry about whether the asset will depreciate more than expected throughout the course of the lease, it is argued that closed-end leases are better for the average person.

Most consumer leases are closed-end leases and provide predictability in monthly payments over the term of the lease, if you stick to the terms, such as mileage limits for a car lease. Open-end leases are more common with businesses that rely on a large fleet of vehicles that put up a lot of miles and need more flexible terms.

Pros and Cons of a Closed-End Lease

Here are the good aspects of a closed-end lease:

No obligation: Under this rental agreement the lessee is not obligated to make a purchase when the agreement ends.

Predictability: A closed-end lease generally carries a fixed rate and a set term. 

Less anxiety: The lessee doesn't need to worry about the asset depreciating more than expected throughout the course of the lease.

And here are the downsides:

Tiered fees: Fees may be structured on a graduated scale where the lessee pays a lump charge for the first few hundred miles beyond the limit, then a cents-per-mile fee after that.

Unexpected expenses:  The lessee is responsible for any excess wear and tear that occurs with the asset. 

Exit fees: Ending the agreement early often means additional fees.

How Closed-End Leases Are Structured

Typically, a closed-end lease comes with a fixed rate and a term that may run 12 months to 48 months. The lessee might want to terminate the agreement early, a move that often incurs additional fees for the early exit. For vehicles procured through such an agreement, there are often annual mileage limits that tend to range from 12,000 miles to 15,000 miles. If the use of the vehicle exceeds those limits, the lessee is then responsible to pay additional fees. Those fees can be based on a set cents-per-mile penalty over the limit.

Such fees may also be tiered or structured on a graduated scale where the lessee pays one lump charge that covers the first few hundred miles beyond the limit, then a cents-per-mile fee beyond that. Furthermore, the lessee is responsible for any excess wear and tear that occurs with the asset.

At the conclusion of a closed-end lease, the lessor might look to sell the asset at its depreciated value. It is possible that the lessee might still seek to purchase the asset at this new rate, and there may even be incentives offered to complete such a deal at a reduced price compared with other potential buyers.

Example of a Closed-End Lease

In an open-end lease, suppose your lease payments are based on the assumption that the $20,000 new car that you are leasing will be worth only $10,000 at the end of your lease agreement. If the car turns out to be worth only $4,000 at the time your lease is over, you must compensate the lessor (the company who leased the car to you) for the lost $6,000 since your monthly lease payment was calculated on the basis of the car having a salvage value of $10,000.

Basically, since you are buying the car, you must bear the loss of that extra depreciation. But if you have a closed-end lease, you do not have to buy the car so you do not bear the risk of depreciation. On the other hand, also in a closed-end lease, if the market value of the car is worth more than $10,000 (the residual value that you would pay for buying the car) it may be a good investment to actually buy the car. For example, if the market value of the car is $14,000 instead of $4,000 in the above example, you could purchase the car for the $10,000 residual value, and sell it at the market price of $14,000 and make a $4,000 profit.

If you're considering taking out a loan to purchase a vehicle instead of leasing it, then you might want to first use an auto loan calculator to determine what kind of loan term and interest rate you'll likely be faced with based on the price of the car.